Lesson 10
Monopoly
Learning Competencies
At the end of the period, the students should be able to:
1. examine the implications of market power;
2. learn the production and pricing decisions of monopolies;
3. understand the implications of monopoly to society as a whole; and
4. evaluate the problems that monopolies raise for society.
Here’s the idea
Monopoly refers to a kind of market structure where a firm is the sole seller of a product
without close substitute. The fundamental cause of monopoly is barriers to entry. A monopoly
remains the only seller in its market because other firms cannot enter the market and compete
with it. Mankiw (2018) presents three main sources in the barriers to entry:
1. A key resource is owned by a single firm.
2. The government gives a single firm the exclusive right to produce some good or
service.
3. The cost of production makes a single producer more efficient than a large number
of producer.
A natural monopoly is a monopoly that arises because a single form cannot supply a
good or service to an entire market at a smaller cost than could two or more firms. It arises
when there are economies of scale over the relevant range of output (Manapat and Pedrosa,
2014).
Cost
ATC
Quantity of output
Figure 27: Economies od scale as a case of monopoly
Figure 27 illustrates the average total cost of a firm with economies of scale. A single
firm can produce any given amount at the smallest cost. That is, for any given amount of
output, a larger number of firms leads to less output per firm, and higher average total cost.
Thus, entering a market in which another firm has a natural monopoly is unattractive. Would-be-
entrants know that they cannot achieve the same low cost. An example of a natural monopoly is
the distribution of water.
Production and Pricing Decisions
Mankiw (2009) explains the production and pricing decisions of the monopolist.
Monopoly has the ability to influence the price of the output. Since he is the sole producer he
can alter the price of its goods by adjusting the quantity it supplies. Its demand curve is the
market demand curve. It has a downward slope demand curve for all the usual reason.
Price
Demand
Quantity
Figure 28: Demand curve of monopolist
Figure 28 shows the demand curve of monopolist. If monopolist raise the price,
consumers buy less. If monopolist reduces the quantity of output it sells the price of its output
increases. The monopolist demand curve provides the monopolist’s ability to profit from its
market power, which is the ability to set a price above that which would occur in a competitive
situation. Monopolist would prefer to change a higher price and sell a large quantity at that high
price. By adjusting the quantity produced the monopolist can choose any point on the demand
curve but not a point off the demand curve.
Monopoly’s Revenue
Table 10: Monopoly’s Revenue
Quantity of Pric Total Average Revenue Marginal Revenue
water e Revenue
0 11 0 0 0
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4
The first two columns show the monopolist’s demand curve. The more it sells more
gallon of water the lower the price.
The third column presents the monopolist’s total revenue. It equals the quantity sold
times the price.
The fourth column computes the firm’s average revenue. It is the amount of revenue the
firm receives per unit sold. Average revenue equals the price of the good, which is true to
monopolist and competitive firms.
The last column computes the firm’s marginal revenue, the amount of revenue that the
firm receives for each additional unit of output.
There is an important understanding of monopoly’s behavior. The marginal revenue is
always less than the price of its goods. This is because a monopoly faces a downward sloping
demand curve. To increase the amount sold, a firm must lower the price of its good.
Marginal revenue is different from what it is for competitive firm. When it increases the
amount it sells, it has two effects on total revenue: first, is the output effect that is more output is
sold, so quantity is higher. Second is the price effect that is if the price falls, so price is lower.
When monopoly increases production by one unit, it must reduce the price it charges for
every unit it sells. The price cut reduces revenue on the units it was already selling. As a result,
marginal revenue is less than its price.
Figure 29: Demand and Marginal Revenue Curves for a Monopoly
Because firm’s price equals its average revenue, the demand curve is also the average
revenue curve. The two curves always start at the same point on the vertical axis because the
marginal revenue of the first unit sold equals the price of the goods. But in monopoly marginal
revenue is less than the price of goods, thus marginal revenue curve lies below its demand
curve. Marginal revenue is negative when the price effect on revenue is greater than the output
effect. When the firm produces an extra unit of output, the price falls by enough to cause the
firm’s total revenue to decline even if it sells more units.
Cost and Revenue
MC
Monopoly price B
ATC
A
Demand
MR
Q 1 Q max Q 2 Quantity
Figure 30: Profit Maximization of Monopoly
If the firm is producing at a low level of output (Q ), marginal cost is less than the
1
marginal revenue. If the firm increased production by one unit, the additional revenue would
exceed the additional costs and profit rises. Thus, when marginal cost is less than the marginal
revenue, the firm can increase profit by producing more units.
At a high level of output (Q ), marginal cost is greater than the marginal revenue. If the
2
firm reduced production by one unit, the cost saved would exceed the revenue cost. If the
marginal cost is greater than the marginal revenue, the firm can raise profit by reducing the
production. Thus, the monopolist’s profit maximizing quantity of output is determined by the
intersection of the marginal revenue curve and marginal cost curve. The rule for profit
maximization in competitive firm and monopoly are alike: marginal cost equals marginal
revenue (MC=MR). But the important difference between the two is: for competitive firm price
equals marginal revenue equals marginal cost (P=MR=MC) while for monopoly price is greater
than marginal revenue and equals to marginal cost (P>MR=MC).
Monopoly’s Profit
Profit is equals to total revenue less total cost
P = TR-TC
or it is
TR/Q – TC/Q x Q.
Take note that TR/Q is AR, which equals the P, and TC?Q is ATC. Therefore:
Profit = (P-ATC) x Q.
This equation is the same for competitive firm.
The height of the box (B and C) is P-ATC, which is the profit on the typical unit sold. The
width of the box (D and C) is the quantity sold Q . Therefore, the are of this box is the
max
monopoly’s total profit.
Cost and Revenue MC
Monopoly price E B
ATC
Monopoly
profit
Demand
ATC D C
MR
Q max Quantity
Table 31: Monopolist’s profit
When a patent gives a firm a monopoly over the sale of a product, firm changes the
monopoly price, which is well above the marginal cost of making the good. When patent runs
out, new firm enter the market making it more competitive. As a result, the price falls from the
monopoly price to marginal cost (Case, Fair and Oster, 2017).
Efficient Level of Output
The monopoly firm is run by a benevolent social planner who care not only about
the profit earned but also about the benefits received by consumer. The planner tries to
maximize total surplus which is equals to producer surplus (profit) plus consumer surplus or it is
equals to the value of goods to consumers minus the cost of making the goods.
Price MC
Value to Cost to
buyers monopolist
Demand (value to
buyers)
Cost to Value to
Monopolist buyers
Value to buyers greater Value to buyers is less
than cost to seller than cost to seller
Efficient quantity
Table 32: Efficient level of output of monopolist
Demand curve reflects the value of the goods to consumers measured by their
willingness to pay for it. Marginal cost curve reflects the cost of the monopolist. The efficient
quantity is found when demand curve and marginal cost curve intersect. Below this, the value to
consumer exceeds marginal cost so increasing output would raise total surplus. Above this,
marginal cost exceeds the value to consumer, so decreasing output would raise total surplus.
Efficient outcome can be achieve by changing the price found at the intersection of demand
curve and marginal cost curve. This price would give consumers an accurate signal about the
cost of producing the good. So consumers buy the efficient quantity (Mankiw. 2009).
Inefficiency of Monopoly
A quantity that is inefficiently low is equivalent to a price that is inefficiently high.
Price MC
Deadweight loss
Monopoly price
Demand
MR
Monopoly quantity Efficient quantity
Figure 33: Inefficiency of monopoly
If monopolist changes a price above marginal cost some consumers value the good at
more than its marginal cost but less than the monopolist price. They do not end up buying,
because the value these consumers on the good is greater than the cost of providing it to them,
which leads to inefficiency.
Case, Fair and Oster (2017) define deadweight loss as the social loss that results from
a decrease in the gains from trade that is not affected as an increase in the monopolist gain.
The wedge cause the quantity sold to fall short of the social optimum.
Monopoly Profit as Social Cost
According to economic analysis of monopoly, its profit is not in itself necessarily a
problem for society. Whenever a consumer pays an extra peso to a producer because of a
monopoly price, the consumer is worse off by a peso and producer is better off by the same
amount. Its monopoly price does not represent the shrinkage in the size of the economic pie. It
represents the bigger slice for producer and smaller slice for consumer. The problem arises
because the firm produces and sells a quantity of output below the level that maximizes the total
surplus (Mankiw, 2009).
The deadweight loss measures how much the economic pie shrinks as a result. This
inefficiency is connected to the monopoly’s high price. Consumers buy less when the firm
raises its price above marginal cost. But the profit earned is not the problem. It stems from the
inefficiently low quantity of output.
Public Policy Toward Monopolies
Government can respond to the problem of monopoly in one of four ways:
1. Increasing competition with Antitrust Laws
The government derives their power over private industry from the antitrust laws – it is a
collection of statutes aimed at curbing monopoly power. It is a comprehensive charter of
economic liberty aimed at preserving free and unrestrained competition as the rule of trade. It
gives government various ways to promote competition.
Antitrust laws have costs and benefits. Sometimes companies merge not to reduce
competition but to lower costs through efficient joint production. These benefits from mergers is
called synergies. Government must be able to determine which mergers are desirable and
which are not. It must measure and compare the social benefits from synergies to the social
cost of reduced competition.
2. Regulation
Another way the government deals with the problems of the monopoly is by regulating
the behavior of monopolists. This is common in the case of natural monopolies such as water
and electric companies where government agencies regulate their prices.
What price should the government set for a natural monopoly? Regulators can respond
in various ways. One way is to subsidize the monopolist. The government picks up the losses
inherent in marginal-cost pricing. Yet to pay for the subsidy, the government needs to raise
money through taxation, which involves its own deadweight losses. Alternatively, the
regulators can allow the monopolist to charge a price higher than a marginal cost. If the
regulated price equals average total cost, the monopolist earns exactly zero economic profit.
Yet average cost pricing leads to deadweight losses because the monopolist’s price no longer
reflects the marginal cost of producing the good. In essence, average-cost pricing is like a tax
on the good the monopolist is selling.
Price
Average total cost Average total cost
Loss
Regulated price Marginal cost
Demand
Quantity
Table 34: Marginal Cost Pricing for a Natural Monopoly
Figure 34 illustrates the marginal cost pricing for a natural monopoly. Because a natural
monopoly has a declining average total cost, marginal cost is less than average total cost.
Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost,
price will be below average total cost and the monopoly will lose money.
3. Public ownership
The third policy used by the government to deal with monopoly is public ownership.
Rather than regulating a natural monopoly that is run by a private firm, the government can
run the monopoly itself.
The key issue is how the ownership of the firm affects the costs of production. Private
owners have an incentive to minimize costs as long as they reap part of the benefits in the
form of higher profit. By contrast, if the government who run a monopoly do a bad job, the
losers are the customers and taxpayers, whose only recourse is the political system. Put
simply, as a way of insuring that firms are well run, the voting booth is less reliable than the
profit motive.
4. Doing nothing
Each of the foregoing policies aimed at reducing the problem of monopoly has
drawbacks. As a result, it is often best for the government not to try to remedy the
inefficiencies of monopoly pricing. Determining the proper role of the government in the
economy requires judgments about politics as well as economics.
